Managing Transitions: The New Challenge

Worries about 'imbalances' are likely to give way to anxiety about 'transitions' in 2010.

For most of the last decade, international economic policy makers such as those in the International Monetary Fund and World Bank repeatedly expressed concern about imbalances. Unsustainable exchange rates, large fiscal and current account deficits and housing price bubbles were the primary sources of their anxiety.

That gave way during 2008 to concerns about the viability of the financial system in many of the advanced industrial countries. While widespread failure of financial institutions is less feared than it had been, the problem has not gone away entirely. Last week, the UK government had to announce new measures to help stabilize the banks within its jurisdiction.

Nonetheless, the emphasis is now more on clearing the debris than on making judgments about survival. In the U.S., as the ATC e-mail highlighted last week, the emphasis is on securing the stable before the next horse escapes.

The bigger issue is now a macroeconomic one of guiding national economies through the transition from recession to recovery. This is likely to be a challenge for all policymakers.

The challenge arises in part because the economics profession is not especially skilled at making its way through such transitions.

Economists can be highly adept at describing current conditions. Hundreds of them are paid for doing just that as they get their heads and their employers names on the cable and free to air business programs every night.

They are also able, with slightly less dexterity, to describe alternative scenarios of where they would like us to be. So, for example, the head of the central bank can describe a 3½% pa GDP growth path with a 2-3% inflation rate and 5% cash rate as an acceptable norm to which we could aspire in the future.

However, economists frequently trip if not fall down completely in working out how to get from current point A to future point B. The tools they have are either too blunt or too uncertain in their impact for them to offer unambiguous prescriptions about how change should be initiated and managed.

Consequently, we are probably going to have a prolonged debate about when fiscal and monetary stimulus should be eased as we attempt to make the transition to more self-sustained growth. Australia's contribution to that assessment has already caught the eye of international commentators some of whom have noted querulously its decision to start tightening monetary policy so early.

One transition which will be of ongoing importance to Australia involves the forces supporting commodity prices.

Currently favorable monetary conditions driven by low interest rates, large budget deficits and central bank quantitative easing have helped keep prices aloft. These conditions cannot persist. Their withdrawal will potentially lead to a sharp fall in prices.

The early stages of an economic recovery typically bring with them a strong surge in demand for raw materials. An acceleration in growth among the advanced economies, of the type now expected in 2010, is the key to this happening.

With luck, one force will take over seamlessly from the other. But we have to consider the possibility that we do not get a seamless transition from markets dominated by favourable monetary conditions to markets depending on a surge in raw material usage. While it lasts a discontinuity between the two will give every impression of another bursting bubble.

I have canvassed these issues in more detail in an article entitled "Commodity Prices: The Transition Risk" to be published in the next edition of the ATC Digest, available on subscription from http://www.atcbiz.com.au/digest.php.

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